Trading patterns in Interest Rate Futures

Exchange traded cash-settled interest rate futures were launched in India in January this year. In its current form, where mark to market differences are settled in cash daily (instead of requiring the delivery of the underlying asset, which is common in international markets) the product offers greater appeal than delivery based versions which were unsuccessfully tried out earlier in 2011.

After a strong initial start however, trading volumes in the exchange traded product have declined. Furthermore, of the six different contracts launched on each of the three major exchanges, the only actively traded contract so far has been the one month futures in the underlying 8.83% Government security maturing in 2023[1]. Average daily traded value of the first month contract (in 8.83 G_Sec 2023) on the NSE exchange today is around Rs. 400 crore per day (Rs. 4 bn) and lower on other exchanges.

While this is concerning, it is too early to comment on the sustainability of the market especially as certain one-off factors have also been at play. We are approaching financial year end which makes it likely for banks to not take risks with a new product before balance-sheet close. Alongside, issuances of Government securities (G-sec) by the Reserve Bank of India have dried up which in turn is keeping the general G-sec market activity low. At the turn of the month as these factors ebb, trading volumes may potentially increase.

In the meantime, we analyse daily settlement prices of the one month futures contract in 8.83% G-Sec 2023 and compare the instrument’s performance up until now. At the onset, it is worth noting that bid-offer spreads in this contract have been remarkably tight (around 1 to 2 paise) which increases the contract’s trading appeal and offers credibility to the information derived from its prices.

A future’s price, as the name suggests, is the value of the underlying security (8.83% G-Sec 2023 in this case) on a future date, normally the expiry date of the contract. On 21st January, when the cash-settled interest rate futures market was launched, the expiry date of the first month contract was 30-Jan-2014; in February it was 26-Feb-2014 and in March it is 27-Mar-2014. In general, the expiry date corresponds to the last Thursday of the month.

Investors can compute a theoretical future’s price by using the market price of the underlying security (8.83% Gsec 2023) and the cost of carrying funds from the spot date[2] to the future’s expiry date. This should ideally be the price of the future’s contract, trading in the market, and any difference may therefore be benefited from by trading one versus the other.

Conversely, since we now have around two months of futures’ price data, we can goal seek the annualised cost of carry priced in the futures market and compare the data with other indicators of cost of funds such as MIBOR and the RBI repo rate. Figure 1 shows this comparison.

Figure 1: Cost of Carry implied by the Futures market vs. other indicators of cost of funds

As can be seen, the cost of carry implied on most days by the NSE interest rate futures market has been lower than the RBI repo rate and the Mumbai Interbank Offer rate. In fact this also implies that the futures contract has been trading at a price somewhat lower than fair value (as had the implied cost of carry been close to the RBI repo rate the futures price would have been higher than the price at which it actually settled).

Given the nascent stage of the market, it is not unusual for the price to trade somewhat away from its fair value. This variance should diminish as trading volumes increase and the market gains maturity.

[1]1-month, 2-month and 3-month future contracts in 8.83% G-Sec 2023 and 7.16% G-Sec 2023 have been launched for trading on the NSE, BSE and MCX exchanges.

[2]In the Indian G-sec market, bonds settle T+1. The spot date will be the date of the underlying security’s price plus one business day.

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